I am writing an article about BitShares, with a focus on BitAssets. More specifically, the article will focus more on the financial arrangements of BitAssets than on the technical arrangements. The objective of my article is to explain the BitAssets arrangement for the layman. This means that I may use a hyper-simplistic approach to describing BitAssets, so that people with no trading experience, and people with no economics background can understand the concepts involved.
There are many people on this forum who are quite sophisticated, and I do not want to insult anyone's intelligence. However, I may ask some very basic questions in the course of my research, and belabor some fundamental concepts in an effort to understand BitAssets well enough to break it down for the uninitiated reader.
I have read Bytemaster's Blog, and I believe that I have a basic understanding of BitAssets, but I still have some questions about the arrangement. I have to first be sure that I understand BitAssets before I can explain it to others. I will start by considering the purely financial aspects of BitAssets, meaning those aspects that are completely independent of technology; those aspects that could have existed five hundred years ago. To convey the spirit of my article, I will begin with some descriptions of conventional trading arrangements.
Loans / Bonds
A loan is an arrangement in which one economic actor lends an asset to another economic actor for a period of time, at a rate of interest. The borrower will generally offer a receipt for this loan, and that receipt is sometimes referred to as a bond, a note, or a bill. Oftentimes, we hear people say things like, “I am going to buy government bonds.” Government bonds have been around for eons, and everyone basically understands that government bonds are government debt instruments. When a person “buys government bonds”, he is not really buying anything. What he is really doing is lending money to the government. In response, the government issues a receipt for the loan. The receipt explains the terms of the loan: duration, interest, etc. This receipt is referred to as a bond (or a note or bill). In conventional parlance, no one belabors the definition of a bond, and people routinely use (slightly) incorrect terminology (such as “buying bonds”), but it doesn't matter, because everyone basically understands how a bond arrangement operates. Nonetheless, in explaining bonds to a middle school or high school student, a proper definition would need to be offered.
exempli gratia: Alice lends 10,000 US dollars to the government. Over a defined period of time, the government pays back to Alice her principal of 10,000 USD, plus a defined interest percentage in USD. (Notice that there is only one asset, USD, involved in this trade. For the purposes of this explanation, we are not defining the receipt (bond) as an asset, even though these receipts are transferable. Also, notice that there are two parties to this trade, Alice and the government.)
A short sale is another long-standing, though creative, means of trading assets. A short sale is different from the loan example given above, as a short sale involves two different assets, whereas the loan arrangement mentioned above only involves a single asset, USD. Also, a short sale involves a sale, whereas the loan arrangement mentioned above does not.
A short sale is a financial arrangement by which one can profit from a decline in the price of one financial asset as compared against the price of another financial asset. In a short sale, a trader borrows an asset from another individual (with appurtenant terms of duration and interest being ignored for the purposes of this discussion; we can consider cost of carry at a later time), then immediately sells that asset into the open market. That is to say that he trades his borrowed asset for some other asset. After some time, the borrowed asset (hopefully) has declined against the asset it has been traded for. At this time, the trader can purchase back the borrowed asset at a lower cost than he sold it for, and give the comparable asset back to the original lender, thereby closing out his short position. He pockets the difference in the price he sold the asset for, and the price he bought the asset back for (minus interest, but we will ignore that for now).
e.g.: Bob borrows 10 ounces of gold from Alice. Bob immediately sells the 10 ounces of gold to Charlie. That is to say that Bob immediately trades the 10 ounces of gold for some amount of (for example) USD. Let's say that he trades the 10 ounces of gold for 10,000 USD, as that is the going rate in the open market. Let's say that, after some time, the price of gold against USD has fallen by 40%. This means that Bob can trade back only 6,000 of his USD to acquire the 10 ounces of gold that he originally borrowed. Bob trades 6,000 USD to Dave, in exchange for 10 ounces of gold. Bob then gives Alice back her 10 ounces of gold (plus interest, but we are ignoring that for now), and he pockets the additional 4,000 USD that he acquired in the trade. He has closed out his short sale for a 4,000 USD profit (minus interest). (Notice that the short sale involves two separate assets: gold and USD. Notice also that there are four parties to this trade: Alice, Bob, Charlie, and Dave.)
Loans Denominated in Other Assets
Let's consider a third, less common arrangement. It is possible to lend an asset with the terms of the loan denominated in a second asset. (Again, we will temporarily ignore the duration and interest considerations of the loan for the sake of clarity.) As an example, one may lend 100 dollars' worth of gold. This means that the asset lent is gold, while the asset which denominates the loan is USD. Like the short sale arrangement mentioned above, this financial arrangement involves more than one asset, and, as such, it also allows for a profit or loss to either trading party, based upon a change in the price relationship between the two appurtenant assets.
e.g.: Alice lends Bob 10,000 USD worth of gold. In response, Bob issues to Alice a receipt (bond) which details the terms of the loan. Let's say that, at the time of the loan, 10,000 USD is equal to ten ounces of gold. Let's say gold rises against the USD to twice its previous value. Bob closes out his loan position with Alice by paying her back 10,000 USD worth of gold at the new exchange rate (plus interest, but we are temporarily ignoring that), and Alice cancels the receipt (bond) detailing Bob's debt to her. This means that to pay back the appropriate amount of gold, Bob only has to pay Alice back five ounces of gold (plus interest). Bob pockets the other five ounces of gold as profit.
Alice loses value on this trade, but, had the exchange rate varied in the opposite direction, Bob would have had to pay Alice back more gold than he originally borrowed from her. (Notice that there are again two assets involved in this arrangement: gold and USD. Notice also that there are only two parties to this trade, Alice and Bob.)
I had said I would ignore interest and duration for the time being, but I can't seem to help myself, so I'll go ahead and describe carry trades. An interest rate is sometimes referred to as a cost of carry. Carry trades are basically subsets of short sales that focus on the different going interest rates for different assets. As in two of the examples above, a carry trade involves more than one asset.
A carry trade is a short sale in which a trader borrows an asset at interest, immediately sells that asset for a second asset, and then lends the second asset at a higher interest rate. To close out a carry trade, the trader calls in his loan of the second asset (plus interest), uses the recalled second asset to buy back the borrowed asset, and pays back the borrowed asset (plus interest). The primary profit motive of a carry trade is to pocket the interest proceeds of the lent asset, which are hoped to exceed the interest costs of the borrowed asset. Of course, there being two assets involved in the trade, profits or losses can also accrue to the trader if the asset price relationship between the two assets changes during the trade. So, we can see that a carry trade is a trade that involves two separate assets with two separate profit/loss potentials (primarily, interest rate arbitrage across two assets; and secondarily, asset price ratio changes).
e.g.: Alice lends Bob 10 ounces of gold at 1% interest. Bob immediately sells the gold to Charlie for 10,000 USD, and lends the 10,000 USD to Dave at 5% interest. After one year, Bob calls, from Dave, his loan of 10,000 USD (plus 500 USD interest), buys, from Erin, 10.1 ounces of gold (at a price of 10,100 USD), returns the 10.1 ounces of gold to Alice as principal plus interest, and pockets the 400 USD as profit. (Notice, in this example, that there are two assets traded, gold and USD. Also notice that there are five parties to this trade: Alice, Bob, Charlie, Dave, and Erin.)
From the four debt-based trading examples given above, we can see that financial arrangements can involve only one asset, or they can involve more than one asset, and they can involve profit/loss potential from a change in price ratios, and also from interest considerations. When only one asset is involved, the lender will typically rely solely upon an interest charge to profit from the arrangement. The borrower will be happy to pay this interest rate, because the borrower's desire for capital is greater than his aversion to the interest rate. However, when more than one asset is involved in a financial transaction, the exchange rate fluctuations between the multiple assets transacted can be a source of profit or loss in addition to the usual interest rate charges. Finally, in some arrangements, there is profit/loss potential derived from the different going interest rates for different assets. So, a financial transaction involving one asset can be viewed as a simple financial arrangement, and a transaction involving more than one asset can be viewed as a compound transaction. Compound transactions allow for short sales, creative loan denominations, and carry trades, all of which improve price discovery and price stability in mature markets.
Mexican Restaurant Menu
I'll use a Mexican Restaurant Menu analogy to demonstrate how one can categorize recipes or other constructs. When one visits a Mexican restaurant, at least if he is not Mexican, he may be confused by the multitude of different items on the menu with exotic names. If the patron does not frequent Mexican restaurants, he may not know the difference between a tamale, a burrito, a tostada, a chalupa, a quesadilla, a flauta, and a chimichanga. Certainly, understanding the differences can be difficult to the uninitiated restaurant guest. However, an experienced waitress can usually clear up the confusion with some categorical assistance. Most Mexican restaurant menus involve dishes consisting of the following options:
1. Corn or flour tortilla
2. Soft or hard tortilla
3. Chicken, pork, beef, or fish
4. Rice, beans, or rice and beans
5. With cheese or without cheese
When one is not certain whether he would prefer a tamale, a burrito, a tostada, a chalupa, a quesadilla, a flauta, or a chimichanga, he may prefer to instead consider the options enumerated above and make a decision, based upon that list. Likewise, when one is considering different debt instruments, he may alleviate confusion by breaking the arrangements into their constituent parts.
Debt Instrument Menu
As we saw from our earlier analysis of the various debt instruments offered in conventional markets, debt-based trades tend to involve the following options:
1. Number of parties to trade (two, four, five?)
2. Number of assets traded (one single asset, or multiple assets?)
3. Number of profit/loss potentials (interest alone as a profit potential; or interest, exchange rate fluctuations, and interest rate arbitrage?)
4. Simple or complex trade? Interpolated trades such as sales or loans within the overall trade?
From this short categorical list, we can analyze the debt instrument menu to discover which categories the various trades fall into.
Based upon my current understanding of BitAssets, I am inclined to think that the financial arrangement listed above, which most closely approximates the BitAssets arrangement, is the third arrangement, which I called “loans denominated in other assets”.
There has been much discussion likening the BitAssets arrangement to that of a short sale, but I believe that BitAssets is more akin to a loan denominated in another asset. Obviously, a BitAssets transaction involves two assets (for example, BitShares and USD), so that separates BitAssets from the first arrangement of a simple loan. In a short sale, an asset is borrowed, and immediately sold. This selling action is missing from the BitAssets transaction, and therefore separates BitAssets from being a short sale. However, in the BitAssets arrangement, a trader may borrow a certain dollars' worth of BitShares, wait for BitShares to appreciate against the USD, and then pay back some portion of the BitShares to close out his loan, and pocket the remainder as profit. I don't believe that a short sale is the proper characterization of the arrangement, as there is no sale involved; only a loan.
e.g.: Bob borrows from Alice 10 USD worth of BitShares (which happens to be 10,000 BitShares). Bob issues a receipt to Alice (or bond, herein referred to as BitUSD), stating the terms of the loan (though we are ignoring interest for the time being). BitShares doubles in price versus USD. Bob returns 10 USD' worth of BitShares to Alice (now amounting to 5,000 BitShares), and Alice cancels the BitUSD which Bob had issued to her as a receipt, thereby closing out the loan. Bob pockets the other 5,000 BitShares as profit. This trade involves two assets, but it does not involve a sale. Also, this trade involves two parties, Alice and Bob. This leads me to believe that BitAssets is basically a loan for which the denominating asset (USD) is different from the lent asset (BitShares).
So, the first question I would like to ask of the BitShares community is whether I have the appropriate understanding of how the BitAssets arrangement is structured. Also, I would like feedback about any errors and omissions. Please remember that, in asking this, I am more interested in understanding the financial structure of the arrangement than I am interested in the technical, digital structure of the arrangement. Thank you for your consideration.